Oil supply concerns have been replaced by oil demand worries.
With investors paying little for undeveloped reserves, the issue of stranded assets inflating oil company valuations has been largely eliminated.
Some companies have been starting to plan for a low-carbon future through investments in lower-carbon natural gas and renewable assets.
The long-term value of oil is uncertain considering the broad uses of oil and gas beyond just burning it in internal combustion engines.
A prime example is a drilling or refining cost/benefit analysis. It generates dramatically different results when a barrel of oil is $100 versus $40. When oil was at $100 per barrel, energy companies were scouring the globe for new oil resources to meet rapidly growing demand. Producers chased higher-cost reserves in deep waters, massive oil sands, deep rock formations and even started exploring in arctic waters. The environmental costs, not viewed as the industry’s problem, were not typically part of the analysis.
The cost/benefit considerations also had implications for renewable energy investments by the major oil companies. Why would an oil company—which specializes in oil production and processing—invest in renewables, where it stood to earn much lower profits and likely had no competitive advantage?
That was Then, This is Now: New Costs, New Benefits
While the equation has not changed, the variables have. Oil prices have declined precipitously in a global environment of sustainability awareness and a push to reduce carbon emissions. The chant of “drill, baby, drill,” has been drowned out by calls to leave oil in the ground.
Climate scientists estimate the world will have to leave much of the coal, oil, and gas in the ground (i.e., stranded assets) in order to help prevent global temperatures from increasing by more than two degrees Celsius above the pre-Industrial Revolution temperature benchmarks. In response, many governments have rolled out aggressive targets to eliminate internal-combustion engines and to increase renewable energy mandates.
The resulting energy industry upheaval has presented companies with a new cost/benefit construct that begs the question: what becomes of discovered fossil fuels? This paper highlights some of the variables that might go into answering this question.
Undeveloped Oil Assets
For decades, the continuation of strong oil demand went unquestioned and companies ascribed significant real and perceived value to undeveloped energy resources. However, with recent oil market volatility, increasing capital costs and uncertainty over future oil demand, the value of undeveloped assets has fallen significantly.
Plans for intricate, high-cost projects seem to be collecting dust. And the true value of undeveloped reserves is debatable. If companies elected to sell these assets, success in a volatile oil market would likely be slim. Given the changing market, companies are choosing to spend exploration capital on only the strongest prospects, with drilling in the Gulf of Mexico, West Africa, Brazil and other areas significantly below pre-2014 levels, when companies were flush with cash from $100/barrel oil prices.
The elimination of carbon dioxide emissions from burning coal would go a long way to reducing the climate change issue. If the world eliminated coal use, the global economy could continue to burn natural gas and oil reserves and would still remain under the 2°C threshold. However, a quick phase-out of coal demand is unlikely. Note that even though China has been reducing coal consumption in favor of cleaner-burning natural gas, coal still accounted for over 66% of China’s electrical generation in 2019.1 It is impractical to expect that number to move to near zero soon.
If we were unable to eliminate all coal burning, and gasoline demand were completely phased out over the next 25 to 30 years, it would likely mean demand for oil would decline by approximately 25%.2 The 15% to 20% of reserves currently held on the balance sheets of oil companies could be impaired under a strict carbon regime.3 Although this could mean the value of all oil companies could be inflated by this 15% to 20%, many analysts have moved away from valuing companies on undeveloped reserves. Many investors and analysts have already placed low-to-zero value on the long tail reserves that need significant capital to develop.
Hydrogen From Hydrocarbons
If we switch to hydrogen for fuel, fossil fuels may still be needed. Why? Because the easiest way to get hydrogen is from fossil fuels. We believe that decarbonizing hydrocarbons is an oft-overlooked path to reduced carbon dioxide emissions. If the industry is able to eliminate or sequester the carbon from hydrogen in the fossil fuel chain, then it is possible that the reserves in the ground do not have to be written down under a strict carbon regime. Pipelines that crisscross the world carrying oil and natural gas could also be repurposed to ship hydrogen fuel, extending the life of these assets. In addition, tankers shipping this fuel would still be needed, albeit with much higher safety standards.
Examples of Stranded Assets Treatments
During the past five years, the major European oil and gas companies exited massive oil sands mines in Canada at very low valuations. By some metrics, these companies gave away these assets to the Canadian acquirers. While these assets have strong free cash flow, the high carbon cost of these reserves was a major factor in exiting these resources. Even the Canadian companies that acquired these assets slowed expansion and further development of new oil sands resources, given both the high carbon cost and the significant capital needed to develop these assets. The total amount of reserves in oil sands is estimated to be 3.5-4 trillion barrels, but only 10% of these reserves are expected to be recovered, with much of these reserves never developed due largely to the high cost of production before even factoring in future carbon costs.4
Venezuela also has significant oil reserves that will likely not be developed. In addition to high production and carbon costs, a volatile political environment has prompted most major oil companies to exit the country during the past 20 years.
To cope with the uncertain outlook for oil demand and the increasing calls for green energy, integrated oil companies (IOCs) in Europe have started to invest in renewable energies and renewable energy companies. Although these companies are investing in renewable energies, oil and gas will likely remain a significant part of their businesses for the foreseeable future, with some companies shifting more capital toward natural gas.This expected shift is because natural gas burns cleaner and has higher demand growth. Expectations that developing economies will switch from coal to gas to help clean up their air could increase demand further. However, while natural gas is seen as a growing fuel, it is often a stranded asset because of its capital intensity. The need for significant processing, pipelines and facilities to liquefy the fuel outweigh the potential benefits.
Fossil fuels do not need to be burned to be useful. They are essential for plastics, lubricants, pharmaceuticals and for intermittent or emergency use. This implies long-term demand for oil—even with a transition to electric vehicles. While this should be positive for refiners, it is worth noting that companies representing the majority of US refining assets already have some of the strongest market caps in the energy space, given strong earnings over the past several years. Investors should be wary of these companies. Oil demand is expected to peak over the next 15 to 20 years and could force many of the higher-cost refineries to shut down. This dynamic could also lead to earnings pressure for even lower-cost refiners near term and eventual death if the world moves away from oil entirely.
With the changing energy landscape, companies are attempting to adjust. However, with massive investments already made in oil and gas, along with lack of expertise in renewable energy, a number of oil and gas companies may not be able to survive. This would leave not only assets stranded, but also valuations of related bonds and equities—and of course investors.
The Growing Concern Over Stranded Assets, by Joel Makower
1 www.CarbonBrief.com, March 20, 2020.
2 Source: Loomis Sayles research and estimates.
3 Source: Loomis Sayles research and estimates.
4 Source: Loomis Sayles research.
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